On November 3, 2023, the U.S. Financial Stability Oversight Council (FSOC) issued a final analytic framework for assessing financial stability risks (the Framework) and final interpretive guidance regarding FSOC’s procedures for designating nonbank financial companies as systemically important (the Guidance, and together with the Framework, the Final Guidance).1 Companies designated as systemically important become subject to supervision by the Board of Governors of the Federal Reserve System (Federal Reserve). FSOC initially issued proposed versions of these documents for public comment in April 2023, and the Final Guidance is broadly consistent with these earlier proposals. Taken together with the speed with which FSOC moved from initial proposal to the Final Guidance, the minimization of changes may suggest that FSOC members and staff already have a sense of the types of nonbank financial companies that they believe pose systemic risks and intend to move rapidly with a regulatory response.
As first discussed in our prior Sidley Banking and Financial Services Update on this topic, the issuance of the Final Guidance should raise concerns for all manner of nonbank financial services providers. FSOC is likely to use the frameworks adopted under the Final Guidance to scrutinize, among others, insurance companies, asset managers, private equity funds, hedge funds, nonbank lenders, nonbank payment service providers, digital asset companies, and mortgage originators. Under auspices of the Final Guidance, should FSOC determine that the material distress or failure of such a business could pose a risk to the financial stability of the United States, such businesses may be designated as systemically important and subjected to supervision by the Federal Reserve as well as enhanced prudential standards (such as capital and liquidity requirements) that would not otherwise apply to such institutions.
FSOC is a multiregulator body, the voting members of which are the heads of major U.S. federal financial services regulators. It was created as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act and has three purposes. First, it is supposed to identify risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected bank holding companies or nonbank financial companies or that could arise outside the financial services marketplace. Second, it is supposed to promote market discipline by eliminating shareholder, creditor, and counterparty expectations that some institutions are “too big to fail.” Finally, FSOC is meant to respond to emerging threats to the stability of the U.S. financial system. While it generally acts as a research, advisory, and interagency coordination body, it is afforded certain significant powers to help fulfill its statutory mandate. This includes, most notably, the power to designate nonbank financial institutions as systemically important and thereby subject them to supervision by the Federal Reserve.
Overview of the Final Guidance
The FSOC proposal, and now the Final Guidance, makes three core changes from the approach to designations that FSOC most recently outlined in 2019. First, the Final Guidance moves from an approach focused on the business activities that pose systemic risk, under which individual companies would be designated for supervision by the Federal Reserve as a last resort, to an approach that allows designation as a first step. Second, the Final Guidance makes clear that FSOC can decide to designate a company as systemically important without first engaging in a cost-benefit analysis as part of its decision-making process. Third, the Final Guidance eliminates the requirement that FSOC consider the likelihood of a company’s experiencing material financial distress before determining that it should be subject to Federal Reserve supervision. Collectively, these changes will make it easier for FSOC to designate nonbank financial companies for supervision by the Federal Reserve and impose enhanced prudential standards.
Under the Final Guidance, FSOC generally expects to follow a two-stage process when designating a nonbank financial company as systemically important. In the first stage, FSOC will notify a company selected for review and perform a preliminary analysis. The company will be permitted (but not required) to submit information to FSOC, and FSOC will also solicit input from the company’s primary regulatory agency. If a company is thereafter selected for additional review, the second stage will consist of an in-depth evaluation, including collection of information directly from the company. If FSOC proposes to designate the company, the company may request a hearing, after which FSOC will make a final decision whether to designate the company. Thereafter, companies will be reevaluated annually to determine whether the designation should remain in place.
Changes From the Initial FSOC Proposal
While the Final Guidance is substantially similar to the proposed guidance, there are a few differences worth noting. While these differences do not appear to be determinative of any subsequent steps that FSOC will take, they are relevant to how firms that may be subject to an FSOC designation may wish to proceed. Of particular note concerning the Guidance, FSOC has added back language clarifying that a company may act during the first stage of the FSOC review process to mitigate the threat its material financial distress or activities could pose to financial stability and thereby potentially avoid the need for designation. However, the adopting release for the Guidance clarifies that FSOC will not delay its review process to provide a company with time to undertake such mitigation and will not advise a company on actions that can be taken at this stage to mitigate and avoid designation.
With respect to the Framework, many of the key changes appear to be best characterized as clarifications rather than material changes. We highlight two of those categories of changes here. First, and perhaps most notably, FSOC added “private funds” to its list of examples of financial entities that could pose risks to financial stability. While this does not change the scope of the Framework, the decision to add that particular example may indicate the thinking of certain FSOC members. Second, the final Framework clarifies or further explains several relevant concepts. This includes adding description of how the phrase “threat to the financial stability of the United States” will be interpreted, adding discussion regarding the channels that FSOC will consider as potential means by which risk may be transmitted, and adding examples of quantitative metrics that FSOC may consider in analyzing risk. These clarifications, though useful in understanding how FSOC will approach designations, do not appear to meaningfully limit the scope of FSOC’s power to do so or otherwise directly suggest the types of nonbank financial companies for which FSOC is likely to initially pursue designations.
Possible Implications of the Final Guidance
FSOC’s actions come at a time when financial regulators are increasingly concerned with the risks to the financial system posed by nonbanks. For example, in a September 2023 speech, Federal Deposit Insurance Corporation Chairman Martin Gruenberg described his concerns regarding the risk that nonbank financial institutions can transmit “into other parts of the financial system and seriously hamper the credit and financial intermediation needed to support the economy.”2 Similarly, in November 2023, Federal Reserve Governor Lisa Cook highlighted her concerns that “vulnerabilities at certain [nonbank financial institutions] could play a key role in amplifying stress associated with tightening financial conditions and slowing economic activity.”3
Given these and other statements, it is clear that federal regulators remain concerned with the systemic risks and potential threats to financial stability posed by nonbank financial institutions. Moreover, with the adoption of the Final Guidance, FSOC now has in place a set of procedures by which it may act on these concerns. Accordingly, to the extent that nonbank financial companies have not yet done so, now would be an advisable time at which to formally consider their systemic risk profile. However, statements by federal regulators, together with FSOC’s past work, may provide useful guidance regarding the types of industries and businesses which FSOC may consider for designation first. As such, we would advise that firms in the following industries — particularly those that are large, interconnected, or otherwise implicate the factors established in the Final Guidance — to pay particular attention to how their business may be evaluated pursuant to the factors described in the Final Guidance (although this list is by no means exclusive).
- Insurance. Of the four nonbank financial companies previously designated as systemically important, three were insurance companies. While these insurers have since been de-designated, the insurance industry was historically a focus of this authority.
- Public Funds. FSOC has prioritized evaluating the risks that open-end funds and money-market funds pose to financial stability and has established several working groups to consider these issues. Indeed, in a March 2023 speech, FSOC Chair and Treasury Secretary Janet Yellen specifically highlighted the risks posed by public funds.4 The Framework’s discussions of fire-sale pricing during asset liquidation likely maps to concerns about open-end and money-market funds.
- Private Funds. FSOC has also prioritized evaluation of the risks posed by hedge funds and has similarly established a hedge fund working group. In her March 2023 speech, Secretary Yellen addressed the prominent role that the hedge fund industry has come to play in U.S. treasury markets and highlighted classes of transactions in Treasury securities that give rise to potential systemic risk. Certain types of private equity funds are also likely to be a focus of FSOC in the coming months and years.
- Payment Services. Consumer Financial Protection Bureau Director Rohit Chopra has suggested using FSOC designation authority to address banklike risks posed by nonbank payment services.5 Specifically, he has described such services as offering “quasi-bank accounts” at-risk of runs on uninsured, “deposit-like” liabilities.6 Assistant Treasury Secretary for Financial Institutions Graham Steele raised similar concerns in September 2023.7
- Digital Assets. In 2022, FSOC published a report identifying risks that digital assets could pose to financial stability and calling for greater regulation of the digital asset industry. Secretary Yellen also raised these issues during her March 2023 speech, indicating that a “comprehensive prudential regulatory framework” was required for stablecoin issuers. Separately, Director Chopra has also expressed interest in designating stablecoin issuers as systemically important.8
Thank you to Sidley Law Clerk Kyle Tillotson for his significant contributions to this Update.
1The analytical framework is effective upon publication in the Federal Register. The designation process guidance is effective 60 days following its publication in the Federal Register.
5 Director Chopra has indicated that such a designation could be under FSOC’s separate payment, clearing, and settlement designation authority. See https://www.consumerfinance.gov/about-us/newsroom/prepared-remarks-of-cfpb-director-rohit-chopra-at-the-brookings-institution-event-on-payments-in-a-digital-century/.
8 Director Chopra has indicated that such a designation could be under FSOC’s separate payment, clearing, and settlement designation authority. See https://www.consumerfinance.gov/about-us/newsroom/prepared-remarks-of-cfpb-director-rohit-chopra-at-the-brookings-institution-event-on-payments-in-a-digital-century/.
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